Fed has almost certainly jumped the gun
Bleak economic and financial market data undermining interest rate forecasts
These are uncomfortable times for the US Federal Reserve.
On December 16, the Fed raised its benchmark interest rate for the first time in nearly a decade, putting an end to the “zero interest rate policy” (ZIRP) that prevailed since the global financial crisis and accentuating the divergence in monetary policy between the United States and the world’s other main central banks, in particular the European Central Bank and the Bank of Japan.
But since the beginning of this year, the rise in US interest rates – and specifically the Fed’s plan to hike rates another four times this year – has looked increasingly premature.
A confluence of bleak economic and financial market data, both in the US and abroad, has conspired to severely undermine the Fed’s interest rate forecasts in the minds of bond investors, who have now all but given up on further policy tightening this year and are even pricing in a significant risk of a US recession in 2016.
While the sudden outbreak of extreme bearishness is almost certainly overdone – since the end of the second world war almost every major recession has been preceded by a sharp increase in oil prices, challenging the prevailing view in markets that the rout in oil prices should be treated as a gauge of the health of the global economy – the challenges facing the Fed have increased significantly over the past month.
The biggest threat is the fallout from the impact of the strong US dollar and plunging crude prices on the US economy.
Last Friday, gross domestic product data for the final quarter of 2015 revealed that the world’s largest economy grew by a meagre 0.7 per cent on an annualised basis (down from 2 per cent in the previous quarter), dragged down by a contraction in exports and investment, with the latter shrinking 2.5 per cent as energy companies – particularly mining groups – cut expenditure sharply.
More worryingly, consumer spending, which accounts for more than two-thirds of US GDP, slowed to just over 2 per cent (compared with 3 per cent in the third quarter), raising the spectre of broader weakness in an economy in which the ailing manufacturing sector has hitherto been the focal point of concern.
Two prominent investors, Jeff Gundlach of DoubleLine Capital and Ray Dalio of Bridgewater Associates, the world’s largest hedge fund, have called on the Fed to halt its monetary tightening cycle. Dalio believes the Fed is jumping the gun given the conspicuous absence of – and increasingly subdued – inflationary pressures. “It behoves central banks to err on the side of waiting until they see the whites of the eyes of inflation before tightening,” Dalio argues.
Market measures of US inflation have indeed been falling over the past several weeks, particularly the so-called “five-year, five-year breakeven rate” (which measures market pricing of five-year inflation beginning in five years) which has fallen to below 1.7 per cent – below the Fed’s 2 per cent target and significant below the long-term average of nearly 3 per cent.
On Monday, Fed vice-chairman Stanley Fischer admitted that a “persistent tightening in financial [market] conditions” could lead to a further decease in US growth and inflation, suggesting that the Fed is seriously considering refraining from hiking rates at its next policy meeting in March.
On Tuesday, the yield on the benchmark 10-year US Treasury bond fell to 1.8 per cent, its lowest level in more than nine months, amid a renewed slide in oil prices and mounting concerns about global growth. The interest-rate-sensitive two-year Treasury yield is now 25 basis points lower than where it stood just before the Fed raised rates in mid-December, throwing the disconnect between the Fed’s policy expectations and those of investors into sharp relief.
The risk is that the Fed’s credibility – which has already been undermined by its dithering over the timing of the first rate hike – is seriously compromised.
The chances of this happening are significant given that the Fed is damned if it does and damned if it doesn’t.
If it sticks to its plans to increase rates further this year, the Fed could exacerbate domestic and international economic vulnerabilities – particularly given the feedback loop between the two.
Yet if the Fed jettisons its monetary tightening plans (or even reverses course) in the face of market pressures, it runs the risk of being perceived as being beholden to investor sentiment, or more “market-dependent” than “data-dependent”.
This suggests the Fed may decide to steer a middle course by simply postponing its plans to raise rates, creating yet more uncertainty about the timing of the next rate hike.
Nicholas Spiro is a partner at Lauressa Advisory